Written Report

Currency is an ancient tool that has evolved to meet the needs of the civilizations that use it. Digital currencies like Bitcoin are the latest in a long line of transaction technologies. Currently, we use several tools: cash, credit, checking, bartering, favors, and others. Each one has certain strengths, and holds a market share based on those strengths (Schlegel 2014). Written communication tools work in the same way, with different technologies meeting different needs. E-mail has a large share of the written communications market, but mail, notes, text messages, and message boards are also used. Bitcoin is already competing with other transaction tools for market share and has quickly gained a small share because it offers benefits that the other technologies do not. As the public becomes better acquainted with Bitcoin’s strengths, we can expect its market share to grow (Harper, 2014).

This paper will focus on a few major transaction technologies in comparison to Bitcoin. The following strengths and weaknesses of cash, credit/debit, and checking will be compared to Bitcoin’s strengths. Cash is accessible and requires no technical knowledge to use it, but is difficult to trace, is relatively expensive in raw materials, and can be counterfeited. Credit/debit cards are the most convenient form of transaction technology to carry, are protected by several laws, and can offer access to lines of credit. On the other hand, they are easily stolen, are frequent targets of fraud, carry a detailed transaction history, and require a third party’s oversight and transaction fees. Checking accounts are guaranteed to some extent and remove the need to carry large amounts of currency, but are not as accessible and are also subject to a third party financial institution. Further, all of these tools are subject to government restrictions. Users select among these transaction tools, considering the strengths and weaknesses of each tool for a given transaction.

Bitcoin has three primary strengths of its own. Bitcoin is decentralized, pseudonymous, and cost efficient. Decentralization removes the need for currency minting and third party or government oversight that is required of other monetary tools. All transactions and currency creation is handled by users and algorithms. No personally identifiable information is ever revealed. Finally, it is cheaper to create, maintain, and transact binary code than it is a physical currency.

Research Design and Assumptions

As a concept, Bitcoin is somewhat complicated but is still accessible to any computer user who puts a few hours of effort into learning. The technologies behind Bitcoin are not new relative to cryptography and the Internet, but their arrangement is novel and worthy of discussion. The context around Bitcoin will carry more discussion, especially its political, decentralizing implications.

Because Bitcoin is such a new technology, most traditional sources are still catching up. News articles, blog posts, online courses, traditional academic sources form the backbone of our research. However, our analysis is greatly supported by the input of experts. We were able to interview a Bitcoin user, advocates of Bitcoin’s potential role in the economy, and a futurist who focuses on transaction technologies[1]. Ideas and experiences from the interviewees guide our discussion and influence our projections. Where we use traditional sources, in many cases we are extrapolating an older technology to fit Bitcoin’s construction and future. Bitcoin users have shown how they leverage Bitcoin’s strengths, and we use those events to forecast the future. It is also important to note that although this is a paper about Bitcoin, the implications could reasonably refer to any digital currency. We are not confident that Bitcoin itself will survive or be the major player in digital currencies, but the arrangement of technologies in Bitcoin and its community of users will, at least indirectly, have the impacts we describe.

Old Technologies, New Arrangements

Bitcoin relies on several preexisting technologies: cryptography, peer-to-peer networks, online transaction and banking programs, algorithms, public ledgers, and currency. Bitcoin treats each of these technologies as platforms, picking the characteristics that contribute to value creation and exchange. Each of them has a primary function or functions, and they interact to give Bitcoin its full functionality. These components are outlined in more detail by Nakamoto (2008) and Ramzan (2013), which also provide the details for the example transaction at the end of this section.

The block chain

The block chain is a public ledger that stores chronologically ordered data in segments called blocks. This key innovation removes the need for third party oversight. All transactions and ownership in Bitcoin’s history are logged here, enabling all users to verify the ownership of the bitcoins used in a transaction. The block chain is written and verified by the entire Bitcoin community through a process called mining, described below. The official block chain is the version used by more than half of the network. The public nature of this type of ledger lends Bitcoin most of its strengths.

Cryptography

The blocks of the block chain are encrypted to control its growth rate and to protect each user’s personal details, including account totals. The system uses public key encryption, which protects users while sharing transaction details[2]. Each block is automatically encrypted and must be decrypted before being added to the chain. This decryption must be done by trial-and-error. With trillions of possible solutions, it takes the entire community about ten minutes to decrypt a block. The user who successfully decrypts the block is rewarded with newly created Bitcoins. This process of decrypting blocks is called mining.

Algorithms

Algorithms define several processes for Bitcoin:

The level of difficulty of block decryption – Blocks should take ten minutes for the entire network to decrypt. As decrypting power changes in the network, the difficulty of the encryption adjusts.

How disagreements about the block chain are settled – When multiple users solve the decryption simultaneously, forks in the chain are created. Eventually, the user who solved the decryption in the most difficult way will earn the mining reward and be the block used in the official chain.

How often bitcoins are added to the economy – Through mining, bitcoins are added to the economy at a rate that decreases every four years through 2140, when rewards will equal zero. At this point, transaction fees will be the incentive for mining.

Peer-to-peer networks

The Bitcoin network is exclusively peer-to-peer; there is no central “Bitcoin server.” Users independently make transactions and work on mining, then broadcast their work to the larger Bitcoin network. This is all automated by the open source Bitcoin software. Human users make transactions and the software manages network communications.

Online transaction and banking programs

Bitcoins are traded through exchanges and wallets, which act like online currency exchanges and banking websites respectively.

Example transaction

The best way to conceptualize these connections is to outline a sample transaction. In this example, all of the above technologies are bolded the first time they are explicitly mentioned. Keep in mind that this entire process is also an algorithm.

Alice is purchasing an item worth one bitcoin from Bob. To conduct the transaction, Alice and Bob agree on the valued exchanged (in this case, one bitcoin) and broadcast that to the peer-to-peer Bitcoin network. Then, using the Bitcoin transaction software, both of their pre-transaction Bitcoin wallet totals are encrypted and logged in a block under pseudonyms. The transaction takes place, transferring one bitcoin from Alice to Bob over the Bitcoin network. These new totals are also encryptedandlogged under pseudonyms.

Miners then decrypt the block where the transactions are logged, verifying that the bitcoins being exchanged are legitimately Alice’s and Bob’s (this is the mining process). The user who successfully decrypts the block is rewarded with bitcoins, and the block is added to the chain, which is broadcasted to the Bitcoin network for approval. All users then know that the bitcoin was sent from one pseudonymous user to the other.

Bitcoin Is Inherently Political

The founding document on Bitcoin, published online by a pseudonymous Satoshi Nakamoto, repeatedly mentions trust. Users of traditional currencies are required to trust that governments, banks, and other financial institutions will accept currencies and will not negate transactions. They must also trust that transactions not involving a third party, like an exchange of a dollar for four quarters, do not include counterfeit currency (Nakamoto 2008). The first block in the chain contains a brief criticism of the bailouts, cementing the creator’s distrust of government currency (“Abridged” 2013). While the document mentions the cost savings of digital currency, it is in the context of eliminating the transaction costs of third party oversight. It does not list cost savings from not minting physical currency (Nakamoto 2008). These omissions make it clear that Bitcoin is designed to remove central authority from transactions.

Bitcoin’s early adopters and advocates are groups with political agendas. Libertarians, anarchists, and those who generally distrust large institutions appreciate the lack of third party control. (Reason-Rupe 2014). These groups also note that Bitcoin can be used for transaction freedom, hiding income and allowing the purchase of illicit goods. They use Bitcoin so they can escape the traditional economy (Stokes 2012). Even non-libertarians take advantage of these qualities. As explained below, Cypriots and Argentinians have adopted Bitcoin at relatively high rates (Bennett 2014; Rose 2014). Advocates of globalization and citizens of pariah states also find value Bitcoin’s open network. Citizens in countries facing international sanctions can subvert sanctions and Bitcoin users do not pay international currency exchange fees (Southurst 2013). Privacy advocates see Bitcoin’s pseudonymous nature as a tool to protect individual rights. Those characteristics mentioned in the introduction (decentralization, efficiency, and pseudonymity) are political because they subvert traditional regulations and norms established by governments and large corporations.

Bitcoin’s disadvantages have political consequences, too. Bitcoins are not protected against loss, like credit, debit, and bank accounts, there is no institutional support, and there is a technological barrier to using Bitcoin. Although Bitcoin and all national currencies are valued because people trust them, national currencies have central banks, laws, and militaries supporting them (Grinberg 2012). Though Bitcoin’s strengths drive people away from governments, its weaknesses highlight the utility of government involvement in transactions.

Bitcoin in Action

Decentralization – Insulation against governments

Governments are heavily involved in transactions and economy, and many users have turned to Bitcoin to take control of their own money. Cypriot citizens turned to Bitcoin when the government seized a portion of all bank deposits greater than 100,000 EUR to pay down its debt. As a result, many wealthy Cypriots are now protecting their savings with Bitcoin, or have used Bitcoin as a conduit to transfer their Euros into another currency (Rose 2014). Argentinian citizens took similar actions following years of more than 25% inflation (Bennett 2014). Bitcoin’s inflation is predetermined, unlike a national currency’s that is subject to global and domestic interference. Citing these crises as a warning of the impacts of government involvement, libertarians in stable countries have adopted Bitcoin. Although these bursts in adoption are only on the scale of thousands, these events show that financial crises will drive people toward Bitcoin.

Bitcoin also provides freedom of transaction against government, who regulate the Internet by restraining the middlemen. Americans cannot make transactions with European gambling websites or Wikileaks because United States law prohibits payment systems like Visa and PayPal from processing those transactions. From the government’s perspective, Visa and PayPal are to Bitcoin as Napster was to BitTorrent; Visa, PayPal, and Napster can be regulated because they are centralized service providers. Napster was shut down because it was a centralized facilitator of music transactions, but BitTorrent continues to share music because it is peer-to-peer (Brito 2014). Bitcoin is also peer-to-peer, providing a true freedom of transactions for users.

Decentralization – Subversion of sanctions

Bitcoin’s decentralized quality also impacts countries’ ability to enforce international policy. American-led sanctions against Iran have been critical in pushing nuclear negotiations forward. The Iranian Rial is one of the lowest-valued national currencies in the world, drastically impacting Iranian citizens’ ability to acquire goods (Hanke 2014). Some Iranian businesses have been using Bitcoin to subvert these sanctions, selling goods all over the world, even in the United States. For example, Iranian shoemaker Persian Shoes has sold hundreds of pairs of shoes to countries that are enforcing currency sanctions by accepting payments in Bitcoin (Southurst 2013).

Efficiency – Cheaper transactions

Bitcoin is cheaper for obvious reasons. Mining eliminates the role of Visa, Mastercard, and their competitors, who charge 3-5% of the value of the transaction in fees. Western Union charges even more, up to 12% for remittances. Bitcoin transaction fees range from zero to 1%, and the transaction fee is set by the buyer, instead of the seller or payment system. These companies charge even more for cross-border transactions. Bitcoin is global, and therefore needs no additional exchange (Brito and Castillo 2014). All users sending payments over a traditional electronic payment system stand to benefit from cheaper transactions, especially those sending remittances by wire transfer services like Western Union. While all of Bitcoin’s strengths have drawn the attention of venture capitalists, Bitcoin’s efficiency has been the main reason they have been funding Bitcoin-based startups.

Privacy – Covering tracks

Bitcoin’s encrypted nature keeps financial data protected from governments and organizations. Data give the government, large companies, and rogue employees immense power over their constituents (Mele 2013, 166-168). While some users may not be concerned by trusted organizations, hacks leave this accumulated data at risk, particularly as demonstrated by the Target data breach and the Heartbleed exploit.

Risks – No protection or regulation

Bitcoin’s most glaring weakness is insecurity. If a user loses access to an account because of a lost password or e-mail address, those bitcoins are gone forever. Likewise, bitcoins stored locally, instead of in the cloud, can be lost if the hardware is lost. Hackers who steal bitcoins at the expense of the user are nearly impossible to catch. For example, Mt. Gox was the premier Bitcoin exchange, but suddenly lost 700,000,000 USD in bitcoins in February 2014. While no one knows exactly what happened, some combination of lost passwords or hardware, hacking, and mismanagement is probable (Winklevoss 2014). Those users who lost bitcoins have no recourse to recover their losses.

Another Piece of the Puzzle

Bitcoin is another tool in the transaction toolbox of people and businesses all over the world. The impacts of decentralization, efficiency, and privacy that we’ve already seen will continue, ultimately strengthening individuals and retail and service businesses and weakening governments and financial institutions. If people fear government intervention with their money or any abuse of their personal data, they will use Bitcoin instead. At the extreme end, governments totally lose their power to set and enforce domestic and international financial laws, including taxes. In this scenario, Bitcoin has the potential to cause violent international conflict because a key nonviolent tool will be removed from governments’ diplomatic arsenal (Schlegel 2014). It is more likely that Bitcoin is a lurking threat to government power that never reaches that level. Because it will be easier to evade taxes, governments will develop innovative ways to levy taxes and provide services, creating space for more diverse transaction options, including non-monetary ones.

However, Bitcoin will not hold a monopoly over the transaction technology market we defined earlier. Bitcoin’s lack of user protection leaves plenty of room for cash, credit, and other transaction tools. People still use cash for small transactions, checking and bank transfers for large purchases, and credit for ease and borrowed money. Bitcoin could become the technology of choice for small business transactions, online payments where detailed personal data is recorded, and international exchanges without impinging on the strengths of the other technologies.

Individuals and businesses will be the direct beneficiaries of Bitcoin, but it stands to have positive, indirect impacts on government and financial institutions, too. Additional competition in our transaction tool market stands to improve all technologies (Reisenwitz 2014). J.P. Morgan is reportedly developing its own monetary instrument based on the idea of a block chain, some United States government agencies are looking toward electronic cash, and companies like Kipochi and M-Pesa are using Bitcoin’s technology as a platform to extend banking services to people in developing countries (O’Leary et al 2013). Bitcoin has already been disruptive, and stands to improve our interfaces across several transaction technologies long-term.[3]

[1] See Appendix for a brief bio of each expert cited in this paper.

[2] Details of public key encryption are beyond the scope of this paper. Other resources go into detail on the technical aspects behind this sort of encryption.